The Natural Rate of Interest and Zero Lower Bound

If rt > rtf

Yt < Ytf

Effects of ZLB on responses

1. Amplifies output responses to IS shocks 2. Dampens output responses to supply shocks 3. In a sense, exacerbates role of price stickiness relative to neoclassical model

Why not fiscal policy for short run stabilization?

1. Mt affects neither rtf nor Ytf 2. Therefore, a well-defined exercise is to pick Mt such that the economy is at a point on the IS curve where (rt,Yt) = (rtf, Ytf) 3. Not so with fiscal policy since Gt and Gt+1 affect rtf

Alternative term for ZLB

Effective lower bound

What is most relevant to the economy?

It cannot be lowered further, it cannot be lowered in response to adverse demand shocks

ZLB and negative output gap

Many feel that rtf fell signifiantly but rt couldn't fall enough because of ZLB, resulting in negative output gap

How is the AD curve for a binding and non-binding?

The AD curve is downward sloping at high price levels (high interest rates) and becomes vertical in a region for lower prices

Rtf

The real interest rate which would obtain in the absence of nominal rigidities

What equation does rtf satisfy?

The total production function Ytf = Ct+It+Gt

How does the ZLB affect the LM curve?

There is a kink to the LM curve

If rt < rtf

Yt > Ytf

Instead of adjusting the money supply

can think of monetary policy as trying to set the real interest rate equal to the natural rate, which automatically implements Yt = Ytf

How is the AD curve for a non-binding ZLB?

downward sloping

Zero Lower Bound

refers to the fact that nominal interest rates cannot go negative under conventional wisdom

How is the AD curve for a binding ZLB?

vertical